Fixed Income: Reinvestment Risk

[Galli]

A bond exposed to the greatest investment risk is one selling at:
A) Par
B) Discount
C) Premium
Answer: C
I’m confused by this answer. I was thinking the YTM on a bond selling at a discount would have more reinvestment risk since the YTM assumes you’re able to reinvest the coupon at the current yield achieved at the time of purchase.
A bit tired so I apologize in advance if i’m missing something very simple

 

[saborio]

If the bond is selling at a premium we can assume that it has a higher coupon. Higher coupon payment = higher investment risk.

 

[breadmaker]

(c) probably has some fat coupons compared to (a) and (b).

 

[Galli]

Doesn’t a bond selling at a discount have a higher yield that a bond selling at a premium? I thought the risk was in the fact that you may not earn the YTM on the discount bond if the coupon isn’t able to be reinvested at the current yield?

 

[saborio]

Investment risk assumes that you can reinvest the coupon at the current YTM whether the bond is selling at a discount or premium. So in that regard both discount and premium bonds have reinvestment risk. However, as the premium bond is ikely to carry a larger coupon we can use the general rule of larger coupon = greater investment risk.
Someone else might be able to explain better though.

 

[S2000magician]

Galli wroteoesn’t a bond selling at a discount have a higher yield that a bond selling at a premium? I thought the risk was in the fact that you may not earn the YTM on the discount bond if the coupon isn’t able to be reinvested at the current yield?

I suspect that the point is that all else being equal (e.g., credit quality, maturity, and so on), two bonds will sell at the same yield; the reason that one sells at a discount while the other sells at a premium is that the former has a lower coupon than the latter.
The characteristics that increase reinvestment risk are:

• higher coupon
• more frequent payments
• amortizing payments (vs. interest only)
• call/prepayment options

 

[Galli]

S2000magician wrote:

Galli wroteoesn’t a bond selling at a discount have a higher yield that a bond selling at a premium? I thought the risk was in the fact that you may not earn the YTM on the discount bond if the coupon isn’t able to be reinvested at the current yield?

I suspect that the point is that all else being equal (e.g., credit quality, maturity, and so on), two bonds will sell at the same yield; the reason that one sells at a discount while the other sells at a premium is that the former has a lower coupon than the latter.
The characteristics that increase reinvestment risk are:

• higher coupon
• more frequent payments
• amortizing payments (vs. interest only)
• call/prepayment options

Ah so that makes more sense if they are selling at the same yield, which means a higher coupon for the premium bond. Got it! A little sleep helped clear it up (along with the good explainations!)
Thank you all for replying!!

 

[S2000magician]

Galli wrote:

S2000magician wrote:

Galli wroteoesn’t a bond selling at a discount have a higher yield that a bond selling at a premium? I thought the risk was in the fact that you may not earn the YTM on the discount bond if the coupon isn’t able to be reinvested at the current yield?

I suspect that the point is that all else being equal (e.g., credit quality, maturity, and so on), two bonds will sell at the same yield; the reason that one sells at a discount while the other sells at a premium is that the former has a lower coupon than the latter.
The characteristics that increase reinvestment risk are:

• higher coupon
• more frequent payments
• amortizing payments (vs. interest only)
• call/prepayment options

Ah so that makes more sense if they are selling at the same yield, which means a higher coupon for the premium bond. Got it! A little sleep helped clear it up (along with the good explainations!)
Thank you all for replying!!

My pleasure.